Online Lending : The Boom To Come

LendingClub and OnDeck Capital have grown big enough to access Wall Street funding, and growing consumer awareness will help them attract new customers. Their revenues and margins are about to shoot up.

March 25, 2016

Executive Summary

Online lending platforms are starting to get some wind in their sails from media coverage. This amounts to free publicity, which will help them attract customers beyond their traditional marketing techniques (such as direct mail).

Online lending volumes have grown past a level where loan securitization starts to make sense for the big Wall Street banks. The companies have a good track record of their lending books, and will have no trouble attracting institutional interest. This will enable online lending platforms to access cheap and limitless funding.

The combination of both trends: more borrowers, and easy funding, is about to disrupt their existing business model, and propel their revenues to the Moon. We believe the stock prices of the two listed lenders, LendingClub and OnDeck capital, grossly undervalue the probability of this scenario.

Analysis

Public awareness for online lending has been rising over the last three years

Although the business has been around for over a decade, the 2014 IPOs of LendingClub (personal loans) and OnDeck Capital (small business loans) have given the practice a more institutionalized status.

Online lending has managed to grow while distancing itself from the negative image of payday loans and shark loans. An investment in LendingClub by Google back in 2012 has further helped legitimize this business.

Online lending has recently suffered two bouts of bad publicity. In December 2015, it became known that one of the lenders, Prosper, had facilitated a loan to Syed Rizwan Farook, one of the San Bernardino shooters. Then, in February, a massive $7.6B Ponzi scheme masquerading as P2P lending collapsed in China.

For both of these events, however, media coverage has focused on the specific cases, and hasn’t suggested a wider problem, or any consequences for the better-regulated, US-based platforms. The possibility that a US-listed online lender is actually a Ponzi scheme is remote: every loan is filed with the SEC (albeit in a succinct form), and auditors contact directly a random subset of borrowers to check that they actually exist.

Lending volumes have grown rapidly, with a good track record

The market for online loans has been growing rapidly. We have based our analyses on the SEC filings of LendingClub and OnDeck Capital. LendingClub functions as a “peer-to-peer” (P2P) platform, enabling retail investors to choose from a batch of borrowers seeking a loan, whom to invest with. OnDeck Capital has a more institutionalized approach, lending to businesses, and funding the loans by selling them to institutional investors. LendingClub provides long-term (3 to 5 year) loans at rates between 6% and 25%, while OnDeck focuses on shorter loans at much higher interest rates (average rate for 2015: 37%, as per its 10-K).

Loan originations, in millions (source: SEC 10-K filings)

The default and charge-off rates for both issuers have been stable over the last years. Unfortunately for our analysis, both companies started their activities in late 2007, so they couldn’t have a reference default rate for loans issued in 2007, the worst year for issued loan performance in recent history.

Both companies account for loan charge-offs on a year-of-issue basis, which is a welcome move. Aggregating them all together would have made for a prettier picture: past defaults would have been offset by the growing amount of total loans. Instead, we have a clear and accurate image of the actual performance of their loan books. Their model of having algorithms crunch the applicants’ profiles, bypassing costly human interaction, has been validated empirically.

In general, we have failed to find discrepancies in their accounting for loan losses, or in their revenue recognition policy.

The rates both companies charge for the loans reward handsomely the risk. Current loans seeking financing at LendingClub are commanding average rates of 10.4% for 3-year loans and 17.7% for 5-year loans (we aggregated the loans listed in the latest prospectus supplement filed by the company at the SEC, for a total outstanding amount of $49M). OnDeck Capital, as mentioned before, managed to get rates close to 37% in 2015.

Online lending companies’ loan books have been growing. They have reached a critical point when securitization starts to make sense. Citigroup sold $337M of bonds backed by Prosper loans in July 2015, commanding Moody’s ratings of A3 ($231M tranche A), Baa3 ($86M tranche B) and Ba3 ($59M tranche C). Should this securitization channel build up (and we don’t see why not), online lenders would have virtually limitless access to capital. The big banks themselves have realized the new market that’s being created, and become increasingly involved.

Goldman Sachs in particular, is trying to set up its own online lending platform, dubbed “Mosaic”. We see this as “too little, too late”: the existing platforms have been around since 2007, and they have built their processes and brands through years of efforts, investing and research. A much better fit for the banks would be to admit that they won’t be able to compete with the lenders on their own turf: user experience and automatic credit profile evaluation. The banks could, however, set up a lucrative business securitizing the loans, and act as intermediaries.

This is a set up a “winner takes all” situation: the first online lender to reach a sufficient volume for its loans to be securitized, will be the first to access Wall Street funding, and will be able to offer more loans, on better terms, to its customers, thus annihilating competition.

The advent of securitization of online lending loans, and the creation of a new asset class, could be a replay of the mortgage securitization boom. Hedge funds in particular should show increasing interest in the riskier tranches of the new bonds. A growing credit market would be welcome by regulators and politicians as well, creating a new, self-reinforcing paradigm.

Lower marketing costs and access to cheap funding is about to disrupt the business model of online lending

The main issue that online lenders are facing is: finding new customers, on the borrower side as well as on the lender side.

Loan securitization will provide cheaper funding, without the need to find thousands of small investors to bundle together.

Furthermore, rising media coverage will help online lending companies in building brand recognition and customer awareness. This free publicity will contribute in reigning in their main expense: sales and marketing. Direct mail can only get you so far (that’s one of their current customer acquisition strategies).

The stocks of LendingClub and OnDeck Capital have performed badly since their IPOs, down roughly two thirds, in a climate that’s been generally negative for startups. We believe that they shouldn’t be valued on their current organic growth assumptions. The two stocks are actually call options on a new consumer finance product, a direct competitor to credit card debt ($733 billion outstanding in the US, as of 2015) and small business loans ($595 billion).

Roadmap & Playbook

Even if the securitization phenomenon doesn’t gain traction, we believe that growing media coverage will be enough to attract new customers, reduce marketing costs and push profits into the green.

Both $LC and $ONDK are currently trading at around $8. We believe that the pricing-in of the new business model based on securitization would create a 2-3 year bull run for the stocks, with revenues growing tenfold, and marketing expenses as a percentage of revenues dropping. On this assumption, we’d buy both stocks (with a bigger allocation to LendingClub due to its market leader status), looking to cash out at $40 per share.

Should this projected trend play out really well, online lending would grab (or add to) a substantial share of the credit card & small business loan market. A mere 20% of these markets adds up to $300B of outstanding loans ($30B to $60B of revenue). Reduced marketing costs and economies of scale attained thanks to automatized processing of loan applications can easily push gross margins into the 10%-20% range. Under this scenario, both stocks would easily reach $100.

An acquisition by any of the big banks is a very real possibility as well.

The industry crashes, due to new regulations, instances of fraud, or runaway loan default rates.

Instances of fraud & identity theft.

Customer complaints, lawsuits.

UPDATED:2016-05-05

Thoughts about OnDeck earnings and its stock getting hammered

The market and analysts continue to value the company based on its legacy business model. They got spooked by the decline in marketplace financing, which led the company to finance more of new loans through its own credit lines, and to keep more of the loan portfolio on its balance sheet. They had to front-load more provisions for loan losses, because they are now keeping a higher percentage of loans on their balance sheet, hence the earnings miss. The lower guidance for the year, was also a consequence of this shift away from marketplace financing.

This is a natural evolution of their business, exactly in line with what we expect. This shift is the cornerstone of our investment thesis. Marketplace financing is a tedious activity, time-consuming and expensive. They needed it to get their originations volume off the ground, but they’re big enough now to ditch it. They will get much better rates, and much easier access to funding, through wholesale, in particular through securitizations. They’re working on it, and are expecting to have a deal done this very month.

Our thesis is that the stock is actually a call option on a whole new business model, where loans are financed by Wall Street banks. This is exactly what’s happening. OnDeck always had trouble with financing, and now they’re shifting to a new source, solving their main headache once and for all. This led to a short-term accounting charge, and the stock crashed by a third (taking LendingClub, the other online lending play, with it). Don’t listen to accountants who only look at quarterly earnings’ figures. We’re looking at the big picture, and we’re loving it.

We expect the stock to go to $40 over the next 2-3 years, so it doesn’t really matter if you get in at $8 or at $5. Online lending is slowly permeating into society’s mindset, more and more people will try it as awareness grows. This is another crucial point: OnDeck’s marketing expenses grew more than revenue, and this put another dent in their earnings. They’re aware of the problem, and are having a hard look at it. Our thesis is that the rising coverage of online lending by the media amounts to free publicity, and this will show in their operating results very soon.
The company is at an inflexion point, where its whole business model is changing into something much bigger, and it’s very exciting.

UPDATED:2016-05-10

LendingClub CEO fired: wow that’s ugly

Renaud Laplanche, LendingClub’s founder and CEO, was ousted overnight. Four days prior, he was still the fintech superstar speaking at the Matins HEC conference. Laplanche was really the face on the company, and one of the most vocal proponents of peer-to-peer and online lending.

The reputational damage in the eyes of the investors was certainly a big factor in the stock’s crash. The question now is, 1. will this affect the company’s standing in the eyes of financial institutions that provide the company with loans, i.e. how instrumental Laplanche was in establishing relationships with the finance community 2. were the two bad transactions a one-off event, or was Laplanche using his company as a personal piggy bank to a wider extent ?

The company didn’t provide a guidance, which leads us to believe that Laplanche’s departure will indeed impact their operations. Or maybe they need to conduct a more thorough audit of their loan book.

On the other hand, the board might have simply taken advantage of an opportunity to oust a powerful and dissenting member, to shake things up, and change the direction the company was taking. Their results were nice enough, with a growing share of their book being financed by banks (indicating a shift from peer-to-peer to a Wall Street funded online lending operation), which was te basis of our investment case.

The one thing we’re really afraid of, is if there’s indeed deep-rooted fraud and irregularities within the company. Only time will tell. After the huge blow to the stock price, we hold on to our initial analysis, and keep following the news flow very closely.